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Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the world? In fact, more than $3 trillion is traded in the currency markets on a daily basis, as of 2009. This article is certainly not a primer for currency trading, but it will help you understand exchange rates and fluctuation.

What Is an Exchange Rate?An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.

Fixed Exchange RatesThere are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

Floating Exchange RatesUnlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market" (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere.

The World Once PeggedBetween 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade. However, with the start of World War I, the gold standard was abandoned.

At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore, that of the global economy.

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. What this meant, was that the value of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.

Why Peg?The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Fixed regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end of 1997, the Thai bhat had lost 50% of its value as the market's demand and supply readjusted the value of the local currency.

Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is there to help create stability in such an environment. It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions.

Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually, this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.

The Bottom LineAlthough the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. While a floating regime is not without its flaws, it has proven to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.